THE STORY
OF
MONETARY
POLICY
II I? i! !
Awhile later, after interest rales had
risen further, members of the construction
industry demonstrated their unhappiness
by sending some two-by-fours to the
Federal Reserve Board.
I hope the cement
industry doesn't get
angry at the Fed.
What the farmers and the butlders were protesting was the Federal
Reserve's monetary policy. But what ts monetary policy, anyway?
The term "money" refers Co cash in circulation and Che amounts that
people and businesses have in bank accounCs, and "credic" means Che
amounts that banks and other lenders can lend.
We expect the economy to perform in certain
ways — ways that are influenced by what
happens to money and credit. For example,
we expect the economy to grow, so that we
can enjoy a rising standard of living.
In other words, we want the economy to provide an
Increasing amount of aoods and services for each American
to enjoy. Economists call that rising "real GDP per
apita." The phrase "per capita" means "oer oersnn."
cap
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REAL GDP PER CAPfTA
"GDP" stands for gross domestic product, the dollar value of the
nation's output of goods and services. Over time, GDP rises for
two reasons — one is that the economy's output increases,
and the other is that prices rise.
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REAL AND ^OMI^AL GDP
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"Real" GDP data eliminate the effects of the price
increase and thus show only the changes in actual output.
We want the economy to grow, not only to
give us a rising standard of livmg, but also
to provide jobs for people who enter the
labor force each year.
Growth is one of our economic ioals. Another is price stability. We
want to avoid an inflationary economy — where you have a sustainec
and rapid increase in the price level.
Inflation is undesirable for several
reasons. One is that inflation is
unfair and maizes some people worse
off because their incomes don't
rise as rapidly as prices.
Inflation also hurts people who lend money at interest
rates that are lower than tlie rate of inflation.
Another way in which inflation hurts is by making
It harder for businesses to plan.
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Inflation sometimes feeds on itself; one set
of price increases lead; to another.
If unchecked, Inflation can lead to hyperinflation,
in which prices rise extremely rapidly.
Hyperinflation has occurred a number
of times — for example in Hungary after
World War II, Argentina in the
19B0's and Brazil In the 1990s. Some
episodes of hyperinflation
have led to great social unrest.
Money and credit must grow
at a pace that allows
economic activity to expand
at a sustainable rate without
excessive price increases.
If money and credit grow too slowly,
people and businesses will not be
able to get the loans they need for
new homes and equipment.
Id really like to
expand my business, but
I can't afford to pay the higher
interest rates you're charging
during this period of stow
money growth.
The lack of funds for loans will, in turn, lead
to stow growth in the economy, or even to
recession — a period in which the output of
the economy actually declines.
The rise in unemployment that occurs during a
recession brings hardship to many people.
If money and credit increase too
rapidly, the result will be inflation.
The responsibility for making sure that the nations
money supply grows at the appropriate rate lies with
the nation's central bank, the Federal (Reserve.
^
There are several different parts of the Federal Reserve System ("the Fed" For sfiort), and they play
different roles in determining and carrying out monetary policy. The Fed is headed by the Board of
Governors in Washington, D.C. The seven governors are appointed to 14-year terms by the President
of the United States with the approval of the U.S. Senate.
One governor's term expires at the end of January
each even- numbered year. The scheduling makes
it unlikely that any U.S. president would appoint a
majority of the seven Fed governors in one term. Of
course, if a governor resigns before the end of a term,
the president gets lo make an interim appointment.
The staggered 14-year terms help insulate the
Fed from day-to-day political pressures. Unlike most
other government officials, the members of the
Federal Reserve Board, including the chairman,
keep their jobs when a new U.S. president comes
into office, and they can't be fired because of
policy differences with the president.
Another factor chat insulates the Fed from political pressure is its nonrellance on
appropriations from Congress. The Federal Reserve's income consists mainly of the interest
that it receives on its large holdings of U.S. government securities.
It's important for the Fed to be free of short-term
political pressure as it fights inflation. Indeed,
some research shows that the more independence
a nation's central bank has, the more success
the country has in avoiding inflation.
The reason that a central bank needs independence is
that fightina inflation requires actions that limit the
grov^th of money and credit, and those actions
may cause some temporary — but unpopular — business
slowdowns and unemployment in the economy.
White the Fed's
decision making is
Independent, the head
of the Federal Reserve
Is required by law to
present testimony
explaining the Fed's
monetary policy plans
to Congress twice a
year. Congress invites
the chairman to testify
at other times, too.
In addition to the Board
o( Governors, the Federal
Reserve System also consists
of Federal Reserve
Banks around the country.
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The seven memt>ers of the Board of
Governors and the presidents of
five Reserve Banks are the voting
members of the Federal Open Market
Committee (FOMC). The FOMC meets in
Washington, D.C, eight llmesa
year, to determine the course of
monetary policy.
The president of the
Federal Reserve Bank
of New York is always a
voting member and serves
as vice chairman of the
committee, while the
presidents of the other
Reserve Sanfis serve
one-year terms on a
rotating basis.
Before reaching its decision, the FOMC
studies a v/ide variety of economic and
financial data. The committee has to
consider, for example, how rapidly the
economy is growing and whether Inflation
appears to be a problem.
The committee also considers the
analyses that the Federal Reserve
Banks prepare reporting
on economic conditions within
their districts.
After reaching a decision on what
monetary policy to pursue, the FOMC
sends instructions to the domestic
money market desk ("the desk') at the
Federal Reserve Bank of New York,
which has the responsibility for
executing the FOMCs policy.
The FOMCs tnstnjctions include
a target for the federal funds
rate, the interest rate banks
charge one another on short -term
loans of excess reserves.
The desk works to keep the federal funds rate at, or
near, the FOMCs target by buying and selling U.S.
government securities, which are lOU's of the federal
government, and certain other types of securities. The
desk conducts these transactions electronically.
The desk's transactions take place with a number of
securities firms that are designated as primary dealers.
These are securities dealers authorized by
the Fed to engage in transactions with the desk. How
does the Fed flecide which primary dealers to buy
securities from or sell to on a particular day?
When the Fed wanis to buy securities, It asks the
primary dealers which securities they choose to sell to
the Fed. The desk Chen selects Chose securities that
best meet its needs for chat day.
The Fed's buying and selling of securities is
known as "open market operations." The term
■'open market" means Chat Che Fed decides which
securities dealers it wilt do business wich on a
parCicutar day. The choice emerges ffom the
"open market" in which dealers compete on the
basis of price and other characteristics of the
securities they buy and sell.
DEALER
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11
Open market operations are intended mainly to
offset fluctuations in ban!* reserves that result
from seasonal or other technical factors.
If the Fed didn't counteract these influences, short
lived, but undesirable, changes in short-term interest
rates might result. One such influence might be a
change in the amount of casli people want to hold.
The amount of cash that Che public holds is
not constant. It increases, for example, during
busy shopping seasons.
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When people withdraw cash from banl<s — to go
shopping, for example — bani(s' reserves and the
amounts they can lend decline.
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If the Fed didn't act to
offset the decline by buying
securities and thereby
adding reserves to the
banltjng system, the result
could be a drop in money
and credit and a rise in
interest rates that could
curtail economic activities.
The Fed does act, though, during the times of the year when bank reserves are low. During those times, the Fed
often buys securities to boost bank reserves. When reserves are unusually high, the Fed often sells securities to
temporarily absorb, or drain, some reserves from the banking system. Thus, the Fed tries to keep bank reserves,
money and credit, and the economy on a smooth and appropriate path.
The Fed was especially busy buying securities tn
late 1999, when people took a lot of cash out
of banks because of worries about possible
bank computer problems In January 2000.
In addition to open market ooe rations.
the Fed has two other major
monetary policy tools: reserve
require
TO
ments and the discount rate.
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Reserve requirements are the portion of deposits that banks have to keep either on hand or on
deposit at a Federal Reserve Bank. For example, if the reserve requirement is 10*, a bank that
receives a S100 deposit may lend %'}0 of that S100, but it may not lend the other $10.
Whoever borrows the S90 is likely to pay someone who wilt deposit the S90 in another bank. That bank in
turn, can lend VOX of S90, or S81. Then the bank that gets the S81 deposit can lend 90* of S81 , or 572.90.
Through this process, the banking system creates money; the level
of reserve requirements influences how much money banks can
create. The higher the reserve requirements, the greater the
restraint on bank lending. If, for example, the reserve requirement
were US, the banks receiving the S100 deposit could lend only S86.
and the bank receiving the SB6 deposit could Send only S73.96.
|100iW
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10% RESERVE
RFOLIIREMENT
The Monetary Control Act of 1980 authorizes
the Fed's Board of Governors to set reserve
requirements no lower than B% and no higher
that 14% on chectiing accounts.
[
In April 1992, the Fed cut the requirement from
12* to 10*. Why do you think the Fed did that?
One reason, according to the Fed, was to put
banks "in a better position to extend credit."
Changes In reserve requirements are infrequent,
though. As of 2006, some 14 years had gone by
without a change.
T
We weren't even
born yet the last timel
reserve requirements j
were changed.
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One reason they are infrequent is that reserve
requirements impose a cost, which is like an added
tax on banks —a cost that other types of financial
firms do not have to bear.
IS
The third tool of monetary
policy is the discount rate,
the interest rate at which
Federal Reserve Banlts make
very short-term loans to
banks. Banks can borrow
from the Fed for any reason.
The rate charged by the Fed
is higher than the federal
funds rale, so banks typi-
cally prefer to borrow from
one another whenever it is
prudent to do so.
I I
An increase In the discount rate is seen as evidence of the Fed's aim to slow the pace of
economic activity — perhaps in order to prevent Inflation. A decrease in the discount
rate is regarded as evidence of the Fed's aim to stimulate the pace of economic activity.
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For example, toward the middle of 2005, the FOMC raised the discount rate repeatedly
in small steps. These increases removed some of the potential for future inflation
caused by very low interest rates stimulating the economy unnecessarily.
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DISCOUNT RATE
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17
By using open market operations, reserve requirements and the discount rate, the
Fed influences the cost and availability of money and credit in the economy.
Over the years, changes in the relationship between the money supply and the economy have complicated the Fed s job
of formulating monetary policy. For many years, changes ir the economy were closely related to changes in a money
supply measure called Ml , which consists of currency in circulation and checking accounts at depository institutions.
CLOSE RELATIONSHIP BETWEEN M1 AND OUTPUT
In the 1980s, though, when banks started paying Interest on checking accounts,
people put a lot more money into checking accounts. As a result of the rapid growth
in M1 , the relatfonshtp between M1 and the economy broke down.
PERCENT GROWTH
30
2S
^-\M.
-10
I960 1965 1970 1975 1980 1985 1990 1995 2000
2009
Similarly, the relationship between M2 (a broader measure that includes savins accounts as well as
M1 ) and the economy broke down in the early 1 990s, when Interest rates were Tow. During this time,
people pulled money out of saving accounts and put it Into financial investments outside of banks —
in investments such as mutual funds that are not included in the money supply.
/^ At least for the
/ time being, M2 has been '
I downgraded as a reliable
\ indicator of financial
\ conditions in the
St/\^^ economy.
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The Fed does, however, pay attention to a
large variety of economic and financial data in
making Its monetary policy decisions.
For example, the Fed considers changes in
employment in the United States, as well as
movements in the unemployment rate, which
tells us the percentage of the people in the
country who want jobs but don't have one.
The unemployment rate is related to the build-up of
Inflationary pressures. For example, when
unemployment Is low and firms want to expand
production, they may not find the key people they need
at current wage levels. Instead, they may have to pay
their own workers higher overtime pay or offer wages
high enough to aitract workers from other firms.
The Fed also looks at a
variety of inflation
measures, including the
consumer price index
(CPi), which measures
changes in the prices
that consumers pay for
things tike food,
clothing, rent and
entertainment.
Sometimes, chanHes ui the prices of commodities, such as lumber and copper, that are
used in the production of many other items can provide early warnings of inflation. '
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international considerations complicate the making
of monetary policy. In particular, international forces.
Including policies of other countries, can have substantial
effects on the dollar e«change rate and U.S. interest rates.
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In recent years, international trade and international
financial activity, such as U.S. bank lending abroad,
have grown rapidly. As a result, the Fed has to be
concerned about the value of the dollar, as measured
in terms of foreign currencies.
i
21
s
When the dollar is strong,
Americans find foreign goods
cheaper to import.
American goods are more expensive, though, so foreigners may
buy fewer of them, reducing U.S. exports and jobs. When the
dollar is weaker, foreigners find U.S. goods cheaper to import,
so U.S. industries can export more.
A weak dollar can aggravate
inflationary pressures in the
United States.
Interest rates are one factor affecting the value of
the dollar. For example, when interest rates are
higher in the United States than elsewhere, foreigners
want to invest their funds here in order to earn a
higher rate of return. The increased demand for U.S.
bonds pushes up the value of the dollar.
I
Making monetary poiicy is a complicated job,
but it's a job that s necessary in order for our
economy to enjoy continued growth along
with stable prices.
"The Story of Monetary Policy" uses non-
technical language and lively Illustrations
to explain:
■ the meaning and purpose of
monetary policy,
■ how the Federal Reserve makes
monetary policy,
■ what factors the Fed considers in
making monetary policy,
■ the tools of monetary policy —
open market operations, reserve
requirements, and the discount
rate — and how they work.
For more information about
New York Fed education
prograrr)s, visit:
www.newyorkfed.org/education
Federal Reserve Bank of New York
Public Affairs Department
33 Liberty Street
NewYork, NY 10045
(212) 720-6134
NOT FOR RESALE
For free copies, visib
www.newyorkfed.org/publications
Reprinted
2006
